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FINC 5880 Session 5 Mid-term Examination 2014

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Question

Question 1. (10 points) The exercise price on one of ORNE Corporation\'s call options is $25 and the price of

 

the underlying stock is $29. The option will expire in 35 days and is currently selling at $5.50.

 

a. Calculate the option\'s exercise value? What is the significance of this value?

 

 

b. Why is an investor willing to pay more than the exercise value for the option?

 

 

c. If the price of the underlying stock changes to $33 per share, will the market value of the option increase,

 

decrease, or remain the same? Why

 

 

d. If Orne Corporation had issued a put option (instead of the call), would its value increase, decrease, or

 

remain the same if the price of the underlying stock increased? Why?

 

 

Question 2. (15 points) Pierre Imports is evaluating the proposed acquisition of new equipment at a cost of $90,000. In addition the

 

equipment would require modifications at a cost of $10,000 plus shipping costs of $2,000. The equipment falls into the MACRS 3-year

 

class, and will be sold after 3 years for $35,000. The equipment would require increased inventory of 6,000. The equipment is expected to

 

save the company $35,000 per year in before-tax operating costs. The company\'s marginal tax rate is 30 percent and its cost of capital is 11

 

percent.

 

a. What is the cash outflow at Time 0?

 

 

Cost of milling machine

 

Modifications to machine

 

Shipping costs

 

MACRS 3 year class

 

Salvage after 3 years

 

Increased inventory

 

Savings per year

 

Tax rate

 

 

$90,000

 

$10,000

 

$2,000

 

0.3333

 

$35,000

 

$6,000

 

$35,000

 

30%

 

 

0.4445

 

 

0.1481

 

 

0.0741

 

 

b. Calculate the net operating cash flows in years 1, 2, and 3?

 

 

c. Calculate the non-operating terminal year cash flow.

 

 

d. Calculate net present value. Should the machine be purchased?

 

 

Question 3. (15 points) Andrews Corporation plans a $10 million expansion. The firm wants to maintain a 45 percent debt-to-total-assets ratio in its

 

capital structure. It also wants to maintain its past dividend policy of distributing 30 percent of last year\'s net income. Last year, net income was $4

 

million.

 

a. Calculate the amount of external equity needed.

 

 

b. If the company changed to a residual dividend policy, how much external equity will it need?

 

 

c. Is the company likely to change to a residual policy? Why or why not?

 

 

Question 4. (15 points) A U.S. company orders merchandise from a Japanese company at a cost of 100 million

 

yen. The merchandise must be paid for in yen

 

 

Spot

 

30-day forward

 

90-day forward

 

180-day forward

 

 

Yen per $1 $ per 1 yen

 

97.57

 

0.01025

 

97.45

 

0.01026

 

96.31

 

0.01038

 

92.45

 

0.01082

 

 

a. How many U.S. dollars must be raised if payment is due today?

 

 

b. Is the dollar appreciating or depreciating against the yen? Explain.

 

 

c. How many U.S. dollars must be raised if payment is due in 90 days?

 

 

d. Who bears exchange rate risk, the U.S. company or the Japanese company or both? Explain.

 

 

e. Describe 3 ways in which the company can reduce exchange rate risk.

 

 

Question 5. (15 points) Kern Corporation entered into an agreement with its investment banker to sell 10 million shares of the

 

company\'s stock with Kern netting $225 million from the offering. The expected price to the public was $25 per share.

 

The out-of-pocket expenses incurred by the investment banker were $5 million.

 

a. What profit or loss would the investment banker incur if the issue were sold to the public at an average price of $25 per share?

 

 

b. What profit or loss would the investment banker realize if the issue were sold to the public at an average

 

price of $20 per share?

 

 

c. Is the agreement between the company and its investment banker an example of a negotiated or a bestefforts deal? Why? Which is riskier to the company? Why?

 

 

Question 6. (15 points) Reynolds Corporation plans to purchase equipment at a cost of $3 million. The company\'s tax-rate is 30

 

percent and the equipment\'s depreciation would be $600,000 per year for 5 years. If the company leased the asset on a 5-year

 

lease, the payment would be $700,000 at the beginning of each year. If Reynolds borrowed and bought, the bank would charge

 

11 percent interest on the loan.

 

a. Calculate the cost of purchasing the equipment with debt.

 

 

Cost of equipment

 

Depreciation per year

 

5-year lease

 

Lease payment -BGN year

 

Loan

 

Tax rate

 

After-tax rate

 

 

Purchase Option

 

CF0

 

 

CF1

 

 

CF2

 

 

CF3

 

 

CF4

 

 

CF5

 

 

CF1

 

 

CF2

 

 

CF3

 

 

CF4

 

 

CF5

 

 

Cost of equipment

 

Depreciation tax saving

 

Total cash flow

 

NPV

 

b. Calculate the cost of leasing the equipment.

 

 

Lease Option

 

CF0

 

Lease Payments

 

Tax saving

 

After-tax payments

 

 

c. Calculate NAL? Should the company buy or lease the equipment? Why?

 

 

Question 7. (15 points) Marcal Corporation is considering foreign direct investment in Asia. The company estimates that the project would require an initial investment of $18 million. and generate positive cash flows of $3 million a year at the end of each of the next 20 years. The project\'s cost of capital is 13%.

 

a. Calculate the project\'s NPV.

 

 

b. The company thinks there is a 50-50 chance that the Asian country will impose restrictions on the company in one year.

 

If the restrictions are imposed, cash flows will be $2,000,000 per year for 20 years. If restrictions are not imposed, cash flows will be $4,000,000 per year for 20 years. Cost of capital remains the same. In either case, the cost will remain at $18,000,000 and cost of capital at 13%. Calculate the value of the real option by waiting one year to decide.

 

 

c. Apart from real options, discuss 3 qualitative factors that the company should consider when making its decision on accepting the new project.

 

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